A Quick Primer on Phantom Equity for Small Business

Incentivizing and retaining key employees should be a priority for small business owners. Many owners are understandably reluctant to give away equity, thereby turning a key employee into a business partner, but there are many attractive alternatives to consider.

A phantom equity plan, for example, provides a key employee a financial award that is tied to the value of the company. The distinction, however, is that the award (sometimes referred to as “units”) is not actual equity (i.e., legal ownership) in the company. In other words, there are no actual shares of stock or LLC membership interests given to the employee.

These plans (also referred to as stock appreciation rights) avoid the drawbacks of providing actual equity to an employee, such as: (i) voting rights, or unforeseen minority rights under state law; (ii) the need for additional agreements, such as a shareholder agreement, which necessarily increases the complexity and cost of implementing an employee retention strategy; and (iii) addressing the various “buy-sell” issues that might arise if the employee is terminated, resigns, passes away, or suffers a disability event that prevents her from being able to work.

The phantom stock plan “units” themselves are credited to the employee with each unit initially corresponding to the value of an outstanding share of company stock. The typical upside of the unit given to the employee is the “appreciation” in value, between the award of the unit and the time the actual benefit is paid out, of the corresponding stock share. There are also other versions of phantom stock plans that allow for the benefit at pay out to equal the total value of the share, not just the appreciation in value.

Actual payment of benefits might be made annually or tabled until the employment relationship is terminated due to retirement, death, disability, or a predetermined date. It is common for the benefit to be paid in installments to protect the company’s cash flow. Another useful aspect of the phantom stock plan is that taxes are deferred until the monetary benefit is actually paid, as opposed to when the employee receives the award of phantom stock units. Payouts are deductible by the company and taxable to the employee as W-2 income.

In summary, phantom equity awards offer a clever and simple approach to providing a key employee with the economic upside of equity ownership, without the legal drawbacks, complexities, and documentation associated with actually giving up an ownership interest in the company. Give us a call to discuss structuring a phantom equity plan for your small business!

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